Bloomberg

Bloomberg | Quint is a multiplatform, Indian business and financial news company. We combine Bloomberg’s global leadership in business and financial news and data, with Quintillion Media’s deep expertise in the Indian market and digital news delivery, to provide high quality business news, insights and trends for India’s sophisticated audiences.

How Surge in Inflation-Adjusted Pay Can Lead Fed to Higher Rates

(Bloomberg) -- One reason to look past the surprise December drop in U.S. retail sales came in a report a day earlier, which showed Americans’ inflation-adjusted wages rising at the fastest pace in more than two years.

In fact, when excluding food and energy prices, growth in U.S. average hourly earnings outpaced so-called core inflation by 1.3 percentage point in the 12 months through January, matching the strongest performance in eight years. Take out housing costs and inflation-adjusted wage growth was 2 percent -- matching the highest since 2009.

The figures signal support for consumer spending, though the real question may be how businesses react to higher wages taking a bigger bite out of profits. Companies could respond by raising prices more aggressively to defend margins, or trying to squeeze more out of their existing workforce, perhaps by investing more in capital equipment.

What they choose may determine what life after the pause looks like at the Fed, assuming growth steadies and concerns abate over financial-market volatility, the trade war and the global economy. Central bankers would probably be inclined to offset higher inflation with additional tightening, but higher productivity growth could also convince them that a stronger economy should be matched with higher interest rates over the long term.

“A productivity rebound will blunt some of the inflationary impulse, but not all," said Carl Riccadonna, chief U.S. economist at Bloomberg Economics . “If businesses get on the bandwagon and start a multi-quarter -- or multi-year -- investment campaign, then you are boosting the underlying growth rate of the economy, and therefore interest rates can settle at a higher level.”

But so far, there aren’t many signs of a productivity rebound or inflationary impulses in the government statistics, and the strength in hiring continues to surprise analysts.

Business investment jumped in early 2018 before cooling in the third quarter. It’s still far below levels to be expected in a strong labor market with low unemployment, according to Srinivas Thiruvadanthai, director of research at the Jerome Levy Forecasting Center.

“In the past when you have had higher wage growth, the complementarity of capital kicks in,” Thiruvadanthai said. “When slack in the labor market dwindles, productivity tends to pick up, but we have not yet seen this commensurate increase in productivity.”

The Fed’s pause gives central bankers some time to see which path businesses take in 2019. At the moment, Fed officials expect economic growth to slow from 2018’s 3 percent pace to something closer to 2 percent, according to projections published in December.

That’s roughly in line with their estimates of the underlying potential growth rate of the economy, which are based in part on the assumption that productivity growth won’t pick up meaningfully.

Strong Consumer

Neil Dutta, head of economics at Renaissance Macro Research, says productivity enhancements via increased investment is the most likely outcome, and sees stronger consumer spending thanks to higher wages also pushing in that direction.

“They should be revising up their longer-run growth estimates,” said Dutta, who predicts U.S. economic growth will be north of 2.5 percent in 2019. “Things are good.”

Others see Fed officials’ projections for a slowdown as more reasonable, and expect companies to live with the pressure instead of stepping up investment.

"Margins are way too high, they’ve been way too high. Companies have had too much bargaining power," said Markus Schomer, chief economist at Pinebridge Investments.

As businesses stay on the defensive, the lack of investment and hiring "will just sap growth," Schomer said. "We will see growth slow this year, and that growth slowdown is what will keep the Fed in line."